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the seller agree to reduce stock to that level by the date you take over the company. Also add a clause to the purchase agreement specifying that you are buying only the inventory that is current and saleable.
     
    TIP
     
    Study the financial records provided by the current business owner, but don’t rely on them exclusively. Insist on seeing the tax returns for at least the past three years. Also, where applicable, ask for sales records.
    • Accounts receivable. Uncollected receivables stunt a business’s growth and could require unanticipated bank loans. Look carefully at indicators such as accounts receivable turnover, credit policies, cash collection schedules and the aging of receivables.
    • Net income. Use a series of net income ratios to gain a better look at a business’s bottom line. For instance, the ratio of gross profit to net sales can be used to determine whether the company’s profit margin is in line with that of similar businesses. Likewise, the ratio of net income to net worth, when considered together with projected increases in interest costs, total purchase price and similar factors, can show whether you would earn a reasonable return. Finally, the ratio of net income to total assets is a strong indicator of whether the company is getting a favorable rate of return on assets. Your accountant can help you assess all these ratios. As he or she does so, be sure to determine whether the profit figures have been disclosed before or after taxes and the amount of returns the current owner is getting from the business. Also assess how much of the expenses would stay the same, increase or decrease under your management.
    • Working capital. Working capital is defined as current assets less current liabilities. Without sufficient working capital, a business can’t stay afloat—so one key computation is the ratio of net sales to net working capital. This measures how efficiently the working capital is being used to achieve business objectives.
    • Sales activity. Sales figures may appear more rosy than they really are. When studying the rate of growth in sales and earnings, read between the lines to tell if the growth rate is due to increased sales volume or higher prices. Also examine the overall marketplace. If the market seems to be mature, sales may be static—and that might be why the seller is trying to unload the company.
     
    WARNING
     
    Who are the business’s employees? Beware, if it’s a family-run operation: Salaries may be unrealistically low, resulting in a bottom line that’s unrealistically high.
    • Fixed assets. If your analysis suggests the business has invested too much money in fixed assets, such as the plant property and equipment, make sure you know why. Unused equipment could indicate that demand is declining or that the business owner miscalculated manufacturing requirements.
    • Operating environment. Take the time to understand the business’s operating environment and corporate culture. If the business depends on overseas clients or suppliers, for example, examine the short- and long-term political environment of the countries involved. Look at the business in light of consumer or economic trends; for example, if you are considering a store that sells products based on a fad like yoga, will that client base still be intact five or ten years later? Or if the company relies on just a few major clients, can you be sure they will stay with you after the deal is closed?

Law and Order
     
    While you and your accountant review key financial ratios and performance figures, you and your attorney should investigate the business’s legal status. Look for liens against the property, pending lawsuits, guarantees, labor disputes, potential zoning changes, new or proposed industry regulations or restrictions, and new or pending patents; all these factors can seriously affect your business. Be sure to:
    • Conduct a uniform commercial code search to uncover any recorded liens (start